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The Risky Business of Commodity Pricing

November 28, 2016

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Though it may seem like it, you don’t really need a degree from the London School of Economics to figure out most economic booms and busts. Consider, for example, the commodities business: oil, copper, nickel—the raw materials that are the lifeblood of so many companies.

Prices have been low for a few years in nearly all categories, as corporate leaders well know. These low prices have been a boon for a host of manufacturers and aerospace companies. Even the lithium for cell phone batteries dropped in price for a couple of years.

While corporate strategizing and fantastic marketing are nice, it was low commodity prices that have really helped keep profits strong at a lot of companies.

The problem comes when business chiefs start making expansion plans based on the idea that the prevailing price levels will continue, or at least stay at a reasonable rate. One thing is certain: These low prices won’t last nearly as long as many people think. When materials prices do start moving up, it can be a swift and brutal event. In a trice, capital planning assumptions made in the CFO’s office can be upended, turning projected profits into huge losses.

The seeds of the next commodity price boom are already being sown. “Exploration for new resources has fallen off the cliff,” says John Dowd, portfolio manager of the Fidelity Select Natural Resources Portfolio.

And it’s no wonder. Oil prices dropped from around $100 a barrel in mid-2014 to a recent low of $26 in early 2016. The mining business also got squeezed, with copper prices down about a third in the same period. In such an environment, where layoffs and other cutbacks at these firms become widespread, who is really thinking hard about digging expensive holes to find more resources? In just the span of a year in 2014, U.S. capital expenditure in the mining and energy sector plunged from a seasonally and inflation-adjusted annual rate of $137 billion to $40.9 billion, according to the latest data from the St. Louis Federal Reserve. “The industry has moved from the investment phase to the exploitation phase,” says Jason Lejonvarn, who leads Mellon Capital Management’s commodity investment strategy.

The reduction in exploration will eventually catch up with the resource industry and everyone else. It works like this: Commodity companies of all types need to replenish depleted mines with new orebodies (or dry oil wells with new, productive ones). The current cutbacks in spending will dramatically reduce future supplies of energy and minerals in a way that cannot be solved quickly when prices start to rise again. Or more simply, when more supplies of copper, nickel or oil are needed in the future, it won’t be like turning on a water hose with instant flow. New orebodies need to be discovered and mines built, which of course takes money. More important, it takes time.

Due to lack of investment, increased demand for materials will not be swiftly met with more supply. That means prices will likely rally with breathtaking speed. Just look at recent history. In June 2008, crude oil reached an all-time peak of around $150 a barrel, up from $11 a decade earlier. In 2006, nickel, a key ingredient in stainless steel, more than tripled in price in just over a year to over $50,000 a metric ton.

Perhaps the most worrisome part of the equation is in forecasting price moves with any degree of accuracy. Resource economists and capital planning analysts don’t have a great track record. The joke is that economists were invented to make astrologers look good. The strategy of many analysts is to use futures prices. That’s a mistake. What the prices of contracts traded on the CME, or similar exchanges, actually tell you is today’s price for a ton of metal (or similar) that will be delivered to you on a designated day in the future. Ultra-long-term contracts, those more than a year into the future, are often so thinly traded that it’s difficult to know if they actually mean anything about future conditions. All of this makes developing capital planning tricky because the raw materials prices are vital to determining profitability.

There is also a further problem, high prices might be the least of the worry. Sometimes it simply isn’t possible to buy what you need at any price. Seasoned veterans may recall the lack of tires for jumbo-sized earth moving trucks about a decade ago. Even at a price of $250,000 per tire there simply weren’t enough available to fill demand.

So what is a CFO to do? Avoiding the problem makes no sense.

Possibly the best course of action is to enter into true long-term partnerships with suppliers. There needs to be an acknowledgement by both parties that prices move up and down over the business cycle and that both the pain and profits will be shared. Such long-term arrangements may limit how much prices fluctuate. At the same time, such a deal would guarantee supplies to the buyer in boom times and assure the supplier of a customer in the bust periods. It’s a question of acknowledging that both parties need each other through thick and thin.